Wednesday, August 12, 2009
Many top economists and economic analysts argue that we have to convert debt to equity to save the economy.
For example, Nassim Nicholas Taleb wrote last month:
The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.
And Nouriel Roubini writes today:
The current rhetoric about the deleveraging process is based on fantasy rather than data. In reality, true deleveraging by households, corporate firms and financial institutions has not really even started as private losses and debts of households, financial institutions and even corporations are being socialized and put on the back of the balance sheet of governments. As a consequence, lending remains impaired while re-leveraging of the public sector leads to an even bigger solvency problem down the line for the sovereign...
To do: The right way to resolve a problem of excessive debt relative to equity capital for households, firms and financial institutions is to reduce such debt and convert it into equity.
Converting debt to equity is not uncommon. For example, it is a common solution for companies which are insolvent. As Wikipedia summarizes it:
It is possible for some organizations to enter into alternative types of borrowing and repayment arrangements which will not result in bankruptcy. For example, companies can sometimes convert debt that they owe into equity in themselves. In this case, the creditor hopes to regain something equivalent to the debt and interest in the form of dividends and capital gains of the borrower. The "repayments" are therefore proportional to what the borrower earns and so can not in themselves cause bankruptcy. Once debt is converted in this way, it is no longer known as debt.Recently, Obama directed GM to convert debt to equity, and he could force the insolvent banks to do the same thing.
Indeed, investors often prefer "convertible debt" (debt that can be subsequently be converted into equity) in certain situations, such as start-up businesses. If the bondholders in the financial giants don't want to convert their debt into equity because they are holding out for a better deal, they should be forced to do so for the good of the economy.Because conversion of debt to equity dilutes the shares of current equity holders, the government would need to educate shareholders about the need for conversion.